APPENDIX B -- Nicaragua

CENTRAL AMERICAN COMMON MARKET

THE CENTRAL AMERICAN COMMON MARKET (CACM), established by
Guatemala, Honduras, El Salvador, and Nicaragua (and later joined
by Costa Rica) with the signing of the General Treaty of Central
American Economic Integration (Tratado General de Integración
Económica Centroamericana) in Managua on December 15, 1960, was one
of four regional economic integration organizations created during
the Latin American export boom of the 1960s. The CACM and the three
other Latin American trading blocs, the Latin American Free Trade
Area, the Caribbean Free Trade Association (Carifta), and the
Andean Group, were generally alike in their initial endorsement of
regional integration behind temporary protectionist barriers as a
way to continue import-substitution industrialization (ISI--see
Glossary).

The basic strategy for development in Latin America was
pioneered in the 1950s by Raúl Prebisch and the Economic Commission
for Latin America and the Caribbean (ECLAC). The "ECLAC approach"
applied a structuralist model of development that emphasized
increasing private and public investment in manufacturing and
infrastructure in order to overcome dependence on exports of
primary commodities. Prebisch argued that continued overreliance on
primary commodity exports as a source of foreign exchange would
eventually lead to economic stagnation and even economic
contraction, as population growth and falling commodity prices
would exert downward pressure on per capita gross domestic product
(GDP--see Glossary). Concurrently, Prebisch and ECLAC recognized
the inherent limitations of ISI based solely on manufacturing for
single-country domestic markets. Particularly for the smaller
countries of the Western Hemisphere, strictly domestic production
of manufactured goods would quickly saturate local demand and would
prematurely reduce returns on capital investment.

In order to overcome the limitations of single-country ISI,
ECLAC proposed to expand the "local" market by means of common
markets among like groups of countries. A common external tariff
(CET) would allow nascent industries to develop by protecting local
manufacturers from extraregional competition.

The ECLAC approach was advanced and widely accepted throughout
the Western Hemisphere as an alternative to both the liberal
export-led growth model and the previous single-country ISI
approach. In practice, however, elements of all three models
coexisted uneasily in most Latin American economies until the mid-
1980s.

Despite their common adherence to the ECLAC model of
intraregional free trade within a protectionist framework, the
various Latin American trading blocs differed from each other in
the size and economic structure of their member states, their
intermediate goals, their institutions, their cohesiveness, and
their relationships to the global economy. In the case of the CACM,
economic disequilibria among member states, incomplete and
unbalanced implementation of the ECLAC-inspired integration scheme,
and the inherent limitations of a development model based on
protection from global competition eventually undermined the CACM
as originally conceived by ECLAC. The CACM's effectiveness waned
following Honduras's withdrawal in the wake of the 1969 Soccer War
with El Salvador. The CACM stagnated throughout the 1970s and
virtually collapsed during the prolonged Central American (see
Glossary) political and debt crises of the 1980s, revitalizing only
after its overhaul and the partial inclusion of Panama in the early
1990s.

INSTITUTIONS

The post-World War II movement toward Central American economic
integration began with a wave of bilateral free trade treaties
signed among Guatemala, Honduras, El Salvador, Nicaragua, and Costa
Rica between 1950 and 1956. By the end of this period of bilateral
negotiations, each country had become party to at least one of the
treaties, which involved free trade in a limited range of products.
The trend toward economic integration was further bolstered by the
formation of the Organization of Central American States
(Organización de Estados Centroamericanos--Odeca) in 1951. Although
primarily a political entity, Odeca represented a significant step
toward the creation of other regional multilateral organizations.

Economic cooperation at the multilateral level began to take
shape under the auspices of ECLAC, which in August 1952 began
sponsoring regular meetings of the Committee of Economic
Cooperation, comprising the ministers of economic affairs of the
five Central American republics. It was through the committee that
ECLAC advanced the Prebisch model of coordinated industrialization
within regional trading blocs. ECLAC's active consultancy efforts
facilitated the signing in 1958-59 of three important integration
agreements: the Multilateral Treaty on Free Trade and Central
American Economic Integration (Tratado Multilateral de Libre
Comercio e Integración Económica Centroamericana), the Integration
Industries Convention (Régimen de Industrias de Integración--RII),
and the Central American Tariff Equalization Convention (Convenio
Centroamericano sobre Equiparación de Gravámenes a la Importación).

The Multilateral Treaty on Free Trade and Central American
Economic Integration provided for intraregional free trade in 239
groups of Central American products and a ten-year phase-in of
intraregional free trade in all Central American goods. The Central
American Tariff Equalization Convention was a complementary
agreement to the multilateral treaty, establishing a CET on 270
products, including all those listed under the treaty, and
proposing a harmonization of tariffs on an additional 200 products
within five years. The tariff equalization convention would thereby
provide the common barrier to extraregional imports under which
Central American producers would conduct a liberalized trade.

The RII was the most controversial component of the ECLAC
program and would be the most difficult to implement. As originally
conceived, the RII was to direct the flow of capital investment
into the region by granting special incentives and privileges to
firms given "integration industries" status. In order to prevent
costly duplication of capital investment, firms whose products had
small consumer markets in the region would be given a virtual
monopoly within the CACM. The Central American countries were
supposed to distribute integration industry plants among themselves
in an equitable and efficient manner.

The integration regime envisioned by the ECLAC-sponsored
agreements never entered fully into force, but was instead
superseded by the General Treaty of Central American Economic
Integration, which became the basis for the CACM. The general
treaty represented a compromise between the ECLAC-inspired approach
and the policy preferences of the United States. The latter
proposed several significant changes to the ECLAC integration
scheme, the main difference being the establishment from the outset
of intraregional free trade as the norm, rather than as the
exception as provided for in the multilateral treaty. Under the
United States plan, all products would be subject to intraregional
free trade unless exempted. The United States was also opposed to
the granting of monopoly status to integration industries within
the region. In exchange for adoption of its plan, the United States
would provide funding for the various institutions of the CACM and
increase its economic aid to Central America.

In February 1960, Guatemala, El Salvador, and Honduras accepted
the United States-sponsored integration scheme and signed the
Tripartite Treaty (Tratado Tripartito) in Esquipulas, Guatemala,
establishing intraregional free trade as the norm and excluding an
RII mechanism. The Tripartite Treaty evoked strong objections from
ECLAC, which saw its guiding role in Central American integration
undermined by United States involvement in the process. In response
to protests from ECLAC and the government of Nicaragua, the United
States and the parties to the Tripartite Treaty agreed to negotiate
a compromise integration treaty to supersede all prior free-trade
agreements. The General Treaty of Central American Economic
Integration was signed in Managua, Nicaragua, by four of the five
republics (Costa Rica delayed signing by two years) on December 13,
1960, with ECLAC conceding on the free trade issue and the United
States conceding on the inclusion of the RII. The general treaty
went into effect for Guatemala, El Salvador, and Nicaragua in June
1961 and for Honduras and Costa Rica in April and July 1962,
respectively.

In addition to the RII, the general treaty established a
permanent Secretariat (Secretaría Permanente del Tratado General de
Integración Económica Centroamericana--SIECA) and a development
bank (Banco Centroamericano de Integración Económica--BCIE). A
Central American Clearing House (Cámara Centroamericana de
Compensación de Monedas) was established in 1963 to promote the use
of local currencies in the settlement of short-term trade deficits
between pairs of CACM member states. A Central American Monetary
Council (Consejo Monetario Centroamericano) was set up the
following year to promote monetary union.

THE CACM EXPERIMENT

During the 1960s and 1970s, the CACM had a significant positive
impact on trade flows in Central America. Intraregional exports as
a percentage of total exports grew dramatically--from 7 percent of
total exports in 1960 to 26 percent in 1970--before declining to
23.4 percent in 1975 and to 14.7 percent in 1985. The total value
of trade within the region grew from US$33 million in 1960 to
US$1.1 billion in 1980, dropping to US$421 million in 1986. By
1967, 95 percent of all goods traded within the region had attained
duty-free status, and 90 percent of traded goods were covered by
the CET. The goods exempted from intraregional free trade were
mainly traditional agricultural exports destined for global
markets.

Most of the new intraregional trade was in consumer goods, a
large share of which consisted of processed foods. By 1970 food
processing was the single most prominent industrial activity within
the CACM, accounting for approximately 50 percent of gross
industrial output. The preference for consumer goods production was
built into the CACM tariff structure, which imposed a high CET on
extraregional consumer goods but did not impede the import of
intermediate or capital goods.

In addition to the protection afforded to consumer goods
production by the CET on consumer imports, CACM member states also
promoted investment in industry by introducing generous tax
incentives and exemptions for new and existing industrial firms. To
help promote balanced development, the Convention of Fiscal
Incentives for Industrial Development (Convenio Centroamericano de
Incentivos Fiscales al Desarollo Industrial) was signed among the
then four CACM member states in 1962 to equalize the granting of
tax incentives to industrial firms. The convention allowed Honduras
and Nicaragua to offer temporarily broader tax breaks to industrial
firms than the other two more industrialized republics. Honduras
became the main beneficiary of this differentiated treatment,
gaining in 1969 an extension of its preferential taxation status.

Another important incentive to industrial development within the
CACM was the implementation of regional infrastructure development
projects. Several infrastructure development organizations were
established during the 1960s to improve intraregional transport and
communications: the Regional Telecommunications Commission
(Comisión Técnica de las Telecomunicaciones de Centroamérica--
Comtelca), the Central American Corporation of Air Navigation
Services (Corporación Centroamericana de Servicios de Navegación
Aérea--Cocesna), the Central American Maritime Commission (Comisión
Centroamericana de Transporte Marítimo--Cocatram), and the Central
American Railways Commission (Comisión Centroamericana de
Ferrocarriles--Cocafer). These organizations were financed mainly
by the Regional Office for Central America and Panama (ROCAP) of
the United States Agency for International Development (AID) as
part of the Alliance for Progress initiative. AID/ROCAP also
financed a Regional Highway Program to improve highway routes
considered vital to intraregional trade.

STAGNATION OF THE CACM

Despite the considerable expansion of intraregional trade and
investment in Central America during the 1960s, by the end of the
decade, the region had not yet achieved the balanced industrial
growth nor the diversification of extraregional exports that was
needed to maintain the momentum of the CACM.
This failure resulted in part from the Central American
governments' inability to implement fiscal modernization or to
overcome persistent structural trade deficits by the less developed
economies of the region. Moreover, the gradual abandonment by
regional economic planners of key components of the ECLAC model,
particularly the goal of monetary union and the Integration
Industries Convention, reduced the potential for joint action on a
broad range of common challenges. Lack of progress on structural
reforms of the Central American economies meant that the CACM would
exist primarily as a customs union, rather than become an economic
community. By the early 1980s, Central America's profound economic
problems and political upheavals had undermined most CACM
activities and institutions.

During the 1960s, Central American policymakers charged with
implementing the ECLAC model were faced with a series of deeply
ingrained social and political obstacles to economic modernization.
Foremost among these were the structural biases in favor of
traditional export agriculture that diverted capital from
industrial investment and discouraged export diversification. Among
the most pervasive structural biases were the antiquated tax
systems that relied primarily on import tariffs as a source of
revenue while undertaxing property and personal income. As free
trade entered into force within the CACM, governments found
themselves forfeiting a large share of their traditional revenues.
In all of the republics except Costa Rica, political opposition to
fiscal reform from the powerful landowning sector prevented
governments from recovering the lost funds through property and
income taxes. Pressure for fiscal reform was offset by a surplus of
commercial bank credit during the 1970s, which allowed Central
American governments to run consecutive fiscal deficits. When the
flow of lending to Latin America ended abruptly in 1982, the burden
of servicing Central American public and private debts caused a
severe regional economic depression. The "lost decade" of the 1980s
was characterized by macroeconomic instability, massive capital
flight, and severe cutbacks in public services.

Monetary and credit policies were also strongly biased in favor
of the traditional export sector, which enjoyed a sharp increase in
commercial bank lending throughout the 1960s. In 1970 a large share
of domestic credit was still being channeled to traditional export
agriculture, which received three times as much credit as did
industry. Moreover, interest rates for traditional agriculture were
in some cases kept artificially much lower than the rates paid by
industry and by nontraditional agriculture.

Despite these inconsistencies in public policy toward
industrialization, manufacturing's contribution to GDP grew
modestly in all of the region except Honduras during the 1960s.
Industrial growth associated with the CACM was generally more
capital intensive than manufacturing for domestic markets, where
small, labor-intensive firms employing ten to twenty workers were
the norm. Rather than producing the desired diversification of
extraregional exports, however, Central America's industrial
development stagnated at the stage of consumer goods production and
became heavily dependent on capital-goods imports paid for with
foreign exchange from traditional agricultural exports. The foreign
exchange constraint that had existed before formation of the CACM
remained essentially unchanged, as competitive export industries
oriented toward global markets failed to develop under the CACM's
protective CET.

Another major drawback of the CACM was its inability to
compensate for disequilibria in capital endowments, in net export
volume, and in productivity among more- and less-developed member
states. As a result, intraregional trade imbalances became
pronounced, and the CACM became polarized between the net
creditors, Guatemala and El Salvador, and the net debtors, Honduras
and Nicaragua. Costa Rica evolved from a net debtor to a net
creditor.

The institutions created by the general treaty to alleviate
structural imbalances among member states failed to operate as
planned. One of the first CACM institutions to be deactivated was
the Integration Industries Convention, which had been negotiated to
help allocate capital investment rationally and fairly among member
states. The convention had been a source of controversy from the
beginning, having been opposed by the United States and excluded
from the earlier Tripartite Treaty. When rivalries arose over the
proposed location of plants, CACM institutions were unable to
mediate the conflicts or to impose solutions. As a result, only two
firms ever attained integration industries status, and the
convention was effectively scrapped in the mid-1960s when a tire
plant was established in Costa Rica to compete with an integration
industries plant in Guatemala.

Another CACM institution that abandoned its original purpose was
the Central American Clearing House. The clearing house had
originally been designed to promote the use of local currencies in
the settlement of intraregional trade deficits. The clearing house
and the Central American Monetary Council were supposed to
represent initial steps toward monetary union. By 1963, however,
the CACM member states had allowed the monetary cooperation effort
to lapse and were settling their trade deficits in United States
dollars twice yearly. Little impetus remained to maintain exchange
rate stability or currency convertibility within the CACM.

RUPTURE OF THE CACM

As the 1960s progressed, unbalanced growth and development among
CACM member states began to take a serious toll on cooperative
efforts in trade, monetary policy, and investment promotion. By the
end of the decade, the CACM had reverted to an amorphous grouping
of economies at different stages of development pursuing
uncoordinated and sometimes antagonistic macroeconomic policies.
The most acute conflict arose between Honduras and El Salvador over
the issues of unbalanced trade, investment, and migration.

By the mid-1960s, chronic Honduran trade deficits with El
Salvador and highly visible Salvadoran investment in Honduras had
led to widespread Honduran indignation and a virtual Honduran
boycott of Salvadoran products. Meanwhile, 300,000 Salvadoran
migrants displaced by the expansion of export agriculture in their
country had settled across the border in Honduras. Capitalizing on
the widespread sentiment against Salvadoran "encirclement," the
government of Honduran President Oswaldo López Arellano (1963-71)
attempted to expel Salvadoran squatters under the pretext of land
reform. Increasing tensions throughout the summer of 1969 erupted
into hostilities on July 14, when Salvadoran air and land units
made an incursion into Honduran territory. The ensuing four-day war
claimed 2,000 lives and led to the forced repatriation of about
150,000 Salvadorans.

Diplomatic and commercial relations between El Salvador and
Honduras were suspended for a decade thereafter, as was air
transport between the two countries. Honduras withdrew from the
CACM in December 1970, after it failed to persuade the other member
states to enact further reforms in its favor. Honduras subsequently
conducted trade with CACM countries on a bilateral basis until
1986. Honduras's withdrawal from the CACM, although not significant
in terms of lost trade volume, represented a symbolic collapse of
the organization as a vehicle for promoting coordinated regional
growth. The prospects for integration had already dimmed
considerably prior to the Soccer War, as evidenced by the piecemeal
abandonment of major components of the original ECLAC integration
plan.

REACTIVATION OF INTEGRATION

Despite Honduras's withdrawal from the CACM and its suspension
of commercial relations with El Salvador, Central American
intraregional trade rose steadily throughout the 1970s, exceeding
US$1 billion by 1980, before halving in the mid-1980s as a result
of accumulated intraregional debts, the overall debt crisis, and
the disruption caused by civil wars in El Salvador and Nicaragua.
Most efforts to coordinate industrial and macroeconomic policies
had been abandoned, however, well before the general treaty expired
in 1982.

A reactivation of Central American economic integration was made
possible with the signing of the Central American Peace Agreement
(Esquipulas II) in August 1987. Esquipulas II laid the political
groundwork for concerted action to renew the integration system
following restoration of peace and democracy in the region. Formal
action to restart the integration process was taken at the eighth
summit of Central American presidents, held in Antigua, Guatemala,
in June 1990. The participants at the Antigua summit approved the
Economic Action Plan for Central America (Plan de Acción Económico
de Centroamérica--Paeca), which foresaw a new conceptual and legal
basis for a Central American economic community.

The new integration initiative emphasizes insertion of the
region's economy into the global economy based on export-led
growth. The industrial base established under the CACM will be
retrofitted and modernized to compete in the international
marketplace, and nontraditional exports will be promoted more
vigorously. Concurrently, the maximum CET for the region is to be
reduced from 40 percent to 20 percent and is expected to average
between 10 percent and 15 percent for most products. With
assistance from the European Economic Community (EEC), a new
Central American Payments System is being established to settle
intraregional debts. The main components of this new payments
system are a revised Central American Clearing House and a Special
Foreign Currencies Fund. The new payments system, backed by a 120
million European Currency Unit (ECU--see Glossary) support fund, is
designed to manage intraregional creditor-debtor relations
multilaterally, rather than bilaterally as under the previous
regime, so that trade deficits will be incurred against the system
rather than against individual countries. In addition, the Special
Currencies Fund, which is backed by an initial EEC support fund of
30 million ECUs, will help the less developed countries in the
region finance the building and improvement of export-related
infrastructure.

Further progress toward integration was made at the tenth
Central American presidential summit, held in San Salvador, El
Salvador, in July 1991, when the five original participants agreed
to include Panama in certain aspects of the new economic community.
The eleventh summit, held in Tegucigalpa, Honduras, modified
several CACM institutions and incorporated them into the System of
Central American Integration (Sistema de Integración
Centroamericana--SICA), an umbrella organization encompassing both
political and economic integration efforts. Honduras fully rejoined
the integration process in February 1992, upon the signing of the
Transitional Multilateral Free Trade Agreement with the other
Central American republics.

Central American integration was given a further boost with the
signing of the North American Free Trade Agreement (NAFTA) among
Canada, Mexico, and the United States. In August 1992, a Framework
Free Trade Agreement was signed among the five Central American
republics and Mexico, establishing the procedures for the formation
of a free-trade area projected to enter into force in December
1996. Inclusion of Central America in a free-trade area with
Colombia and Venezuela was also foreseen in the Caracas Commitment
adopted at a regional summit in February 1993. Guatemala's
recognition of Belize in September 1991 made it possible to begin
free-trade agreement talks with the Caribbean Community (Caricom),
the successor to Carifta. Central America's economic convergence
with NAFTA, the G-3 (Mexico, Colombia, and Venezuela), and Caricom
is expected to further the objectives of the United States-
sponsored Enterprise for the Americas Initiative (see Glossary),
which foresees the eventual formation of a Western Hemisphere free-
trade zone.

* * *

Several detailed studies of the institutional development of the
CACM through the 1980s are available; however, no comprehensive
treatment of Central American economic integration efforts since
Esquipulas II has yet been published. The earlier works include
Economic Integration in Central America, an extensive 1978
study edited by William R. Cline and Enrique Delgado; and Victor
Bulmer-Thomas's The Political Economy of Central America Since
1920, which places the CACM within the context of historical
patterns of development in the region. More recent information on
economic and political integration efforts in Central America can
best be obtained from biannual issues of Revista de la
Integración y el Desarollo de Centroamérica, published by the
BCIE, and various numbers of Panorama Centroamericano,
published by the Instituto Centroamericano de Estudios Políticos.
Statistical data on CACM member states are available from various
SIECA publications, including Cuadernos de la SIECA,
Estadísticas Analíticas del Comercio Intracentroamericano,
and Series Estadísticas Seleccionadas de Centroamérica.
Current reporting of Central American economic developments is
available from Latin American Weekly Report, Latin
America Monitor, and the Economist Intelligence Unit's
Country Reports and Country Profiles on Central
American countries. (For further information and complete
citations, see Bibliography.)